A Natural Gas Recovery Is a Pipedream

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Despite a recent rally, natural gas has fallen so far that experts and Fools alike are calling for a recovery. But like a stock, just because a commodity is down doesn't mean it's going to go back up.

I've been hearing that natural gas is set to bounce back for years as the gap between natural gas and the price of oil has widened. But who cares? There's no good reason that natural gas and oil prices should be linked. They're used for completely different things, and the storage and supply dynamics couldn't be more different.

So let me outline a few things you may want to consider before making a bullish bet on the price of natural gas.

More natural gas than we can use
Low demand hasn't helped the price of natural gas recently, but extremely high supplies are the real driver of the long-term price drop.

There has been so much supply recently that Chesapeake Energy (NYS: CHK) is cutting production by as much as 1 billion cubic feet per day. But that hasn't stopped everyone else from increasing supply. Range Resources (NYS: RRC) increased its proved reserves by 14% and said it replaced a whopping 850% of 2011 production.

With 141 trillion cubic feet of gas estimated by the U.S. Department of Energy to be recoverable, there's more natural gas than we can use and production isn't stopping anytime soon.

The marginal cost conundrum
Marginal costs are the costs associated with the next unit of production. In the case of the current leaseholds in the U.S., it doesn't matter if the natural gas price is so low that overall companies will be operating at a loss, what matters is whether the cost of producing the next cubic foot of natural gas is higher or lower than the price of natural gas.

Leases vary state-to-state and property-to-property, but many leases include upfront payments and limited time to drill on the land. That means there's a sunk cost associated with not drilling for natural gas producers and the marginal cost is much lower than the overall cost.

So producers have incentive to keep producing natural gas even though the price may be so low they're operating at a net loss.

This will also affect prices in the future. If the price of natural gas rises, more wells will become profitable on a marginal basis and more natural gas will hit the market, pushing the price of natural gas down.

Essentially, there's limited upside unless the supply/demand balance changes dramatically.

Too many competitors
There are also too many competitors in the natural gas business who need to produce product just to stay in the game. ExxonMobil and Chesapeake are big enough to adjust production and remain profitable, but others aren't.

Quicksilver Resources (NYS: KWK) has been punished in the past year because of low prices and has struggled with a pile of debt. Most natural producers also have oil exposure and pure plays haven't performed well given the price of natural gas. Even Chesapeake is trying to increase its liquids exposure because it's afraid the natural gas business will remain a weakness.

How to make money from cheap natural gas
If you're going to play natural gas, I would look at companies that will benefit from low prices, not companies that need the price to rise to remain profitable. Clean Energy Fuels (NAS: CLNE) is one of the companies that will leverage the low price of natural gas to provide lower-cost fuel to trucks and commercial vehicle fleets.

And if the fuel is cheap, we need a way to build natural gas vehicles, which is where Westport Innovations (NAS: WPRT) comes in. The company provides the technology to build and convert engines to run on natural gas. By partnering with companies like Cummins and others, the company will be a big winner in a natural gas society.

Remember that just because something goes down, doesn't mean it has to come back up. I think there are plenty of reasons to believe that natural gas will remain depressed for the long term, something to consider when you're picking natural-gas-related stocks.

Whether you're betting on natural gas or oil, there's one company our analysts have identified as a great stock to own. We reveal the company in a free report called "The Only Energy Stock You'll Ever Need."

At the time this article was published Fool contributorTravis Hoiumdoes not have a position in any company mentioned. You can follow Travis on Twitter at@FlushDrawFool, check out hispersonal stock holdings, or follow his CAPS picks atTMFFlushDraw.Motley Fool newsletter serviceshave recommended buying shares of Cummins, Range Resources, Westport Innovations, and Chesapeake Energy. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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